Tool Plans: On the Death Watch List?

By Todd Taggart & Ben Spector

On March 18, 2011, the IRS launched its latest attack on “tool plan” reimbursement programs in a Chief Counsel Memorandum, stating that many of these programs violate IRC §62’s business connection requirement.

A little background: A tool plan is a system some employers use to reimburse employees for tools the employee needs to perform his or her job. Employers normally hire third-party administrators to provide a valuation of an employee’s tools. The administrators base their valuations on any receipts provided, and use estimates when the employee does not have receipts. This valuation then becomes the reimbursement amount.

Using this figure, payroll then splits the employee’s wages in two: 1) a reduced hourly wage (with employment taxes withheld and paid) and 2) a nontaxable reimbursement payment, calculated as a set percentage of the employee’s hourly wage. Once the employee receives an amount equal to the cost of his or her tools, then the employee’s pay returns to the full hourly wage rate. These plans typically are sold by third-party vendors and purport to offer significant tax benefits to employers and employees as tax-favored accountable plan reimbursements.

The IRS contends that employers who base the reimbursements on estimates, pay these reimbursements by the hour, or pay for tools purchased prior to employment are not entitled to the same tax-free reimbursement treatment afforded many other types of expenses. They view this as an arrangement that does not change the underlying economics of an employer’s wage payments. So, going forward, employers who wish to reimburse employees for tools will need to tread carefully and should study this and other IRS guidance to make sure it will pass muster as an accountable plan.

Todd Taggart, CPA, CCIFP, is a Partner at Grant Thornton LLP. He coordinates construction taxation services for contractors and is Grant Thornton’s National Construction Practice Leader. He can be reached at 612-677-5193 or todd.taggart@us.gt.com.

Ben Spector, JD, is an Associate in the Compensation & Benefits Consulting group of Grant Thornton LLP. He can be reached at 612-677-5549 or ben.spector@us.gt.com.